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What is a security token? Everything you need to know

security token
(Image credit: Shutterstock / Netfalls Remy Musser)

Over the last two years, security tokens have gone from a promising concept to a hot-topic issue. PWC revealed that 380 token offerings raised a total of $4.1B in the first ten months of 2019 and that between 2017-2019, established financial institutions conducted over $4.2B of corporate directly-issued security token offerings. Despite factors such as identity, governance and compliance presenting barriers to overcome, investors, institutions and regulators are starting to take note. This is enabling digital securities on the blockchain to make strides towards shaking up both traditional capital markets and the blockchain landscape. 

For example, the Sustainable Digital Finance Alliance (SDFA) and HSBC Center of Sustainable Finance recently joined forces to highlight how security tokens for green bonds can reduce management costs and increase operational efficiency by up to ten times. And in early 2020, RedSwan CRE Marketplace tokenised $2.2B in commercial real estate, making it one of the biggest tokenisations we’ve seen so far and one that illustrates how digital assets can shift traditionally illiquid markets.

About the author

Thomas Borrel is Chief Product Officer at Polymath

With the backing of financial institutions like HSBC, the support of regulatory bodies and more evidence illustrating their benefits, security tokens are set to take the blockchain, securities and finance industries by storm.

The definition of security tokens

Security tokens (or digital securities, as they’re sometimes called) are digital representations of an asset such as equity, fixed income, real estate, investment fund shares, commodities and structured products that are traded and held on a blockchain (a distributed ledger). What makes these assets ‘securities’ is that they’re regulated, with governing bodies across the world dictating how they can be issued, managed, and exchanged. By leveraging blockchain technology, security tokens allow for many traditionally cumbersome and highly-manual processes to be automated, and provide a golden source of truth that all parties can depend on. In short, security tokens combine the speed and ease of blockchain with the strong legal protection of traditional securities.

What are the advantages of security tokens?

Security tokens offer a host of benefits over traditional securities, including:

Efficiency: Blockchain’s automation, speed and transparency make creating, issuing and transferring securities faster and cheaper. By automating traditionally labour-intensive processes, security tokens expedite efficiency while keeping costs down and reducing the risk of manual errors.

Liquidity: Thanks to fractional ownership and secondary markets, security tokens make traditionally illiquid assets like real estate and fine art more liquid for asset owners. Breaking ownership down into tiny fractions - rather than just being owned by a single person or entity - democratises access to wealth creation for smaller investors.

Transparency: The status of a security token transaction can be monitored all the way from initiation to settlement, and all relevant parties have access to an up-to-date golden source of truth on-chain. With an up-to-date record, it reduces disputes around record keeping and the need for parties to reconcile.

Reduced risk: Security tokens enable compliance rules and controls to be programmed into them. By automatically finding problems before the trade is initiated, the risk of wrongdoing decreases.

How are security tokens created?

Creating a security token involves reserving and naming your token symbol, building a token that can programmably enforce regulatory compliance, and minting and distributing the token to investors. There are two ways this can be done:

Asset tokenisation: When a traditional financial asset that exists off-chain is represented on-chain, making it a tokenised security. A good example would be tokenising an existing share certificate.

Asset origination: When the financial asset is defined and exists only on the blockchain. These assets are often described as ‘natively digital securities’.

Asset origination offers a great way to create financial products that can't be created using traditional means.

What issues are holding back security token adoption?

Security tokens have had a great start in revolutionising traditional asset ownership. But there are several challenges acting as roadblocks to their acceptance and adoption by institutions, regulators and issuers, including:

Identity: Regulation dictates that securities must be associated with an identity. However, general-purpose blockchains were built for censorship resistance and pseudo-anonymity. On public blockchains, tokenholders can subvert rules by holding assets under multiple digital identities and carry out Sybil attacks - where one person tries to take over a network by creating many pseudonymous digital identities.  For trade to be compliant, they must be determined by known, trusted, regulated entities - a difficult achievement on public blockchains.

Compliance: Security tokens are subject to a variety of complex regulations and we expect these to grow in number and complexity. Many participants have implemented proprietary systems, but they require manual intervention and are yet to deliver the end-to-end automation that’s necessary for automated compliance. Further, general-purpose blockchains make it challenging to deploy a complex compliance framework. Built on top of the chain, these layer 2 applications can automate key steps. However, as users begin to layer on successive rules for their compliance, the number and complexity of these rules can push the chain to its computational limits, driving up costs and processing time. In turn, this can limit the opportunity to innovate and automate. 

Confidentiality: Financial institutions value confidentiality. Banks want to keep their trading patterns under the radar, because that’s how they differentiate themselves. On public, general-purpose blockchains, this can be exposed. Layer 2 solutions provide confidential transactions and balances, but they come with an unworkable compromise: to add transaction privacy, they must sacrifice the ability to configure compliance rules or enable key reporting capabilities, such as ownership. 

Governance: Because of their decentralised nature, a blockchain can be split into two separate chains, known as a fork, which can expose major legal and tax challenges for tokens backed by real assets. If an investor owns 1 ounce of tokenised gold, they will not get a second ounce of gold when the blockchain forks and the asset is duplicated, because the extra gold doesn’t exist in the real world. It may also not be practical for it to be split into two tokens worth half an ounce each. This is why it’s essential that a blockchain for securities has a governance process that can mitigate contentious forks. 

The security token landscape is taking steps in the right direction to overcome these hurdles. New and traditional market participants are collaborating more often and institutions across the world are realising the opportunities security tokens present. From the widely-used ERC 1400 security token standard launched in early 2019 that reduces the need for technical due diligence, to the institutional-grade purpose-built blockchain technology that’s specifically designed for security tokens on the horizon, the case for them is strong - and growing quickly.

Thomas Borrel is Chief Product Officer at Polymath